In recent months, stock market participants have been focusing on downside risks in 2019, but not all risks are to the downside.

Five global upside risks for investors in 2019 include: no yield curve inversion, a U.S.-China trade deal, a rebound in China’s economy, no (disorderly) Brexit, and a change in market leadership.

Whether or not these particular surprises come to pass, a new year almost always brings surprises of one form or another. Having a well-balanced, diversified portfolio and being prepared with a plan in the event of an unexpected outcome is a key to successful investing.

By Jeffrey Kleintop

We typically start off the New Year with a look at the biggest downside risks for investors in the year ahead. This year, our outlook prepares investors for a challenging year. With stocks falling sharply in recent months, the market has already been focusing on the downside risks, so it may make more sense to reflect on potential upside surprises.

Five Potential Upside Surprises for Investors in 2019

History shows us that the biggest risks in any year aren't usually from out of left field (although that sometimes happens), rather they are often hiding in plain sight. As goes one of my favorite quotes: "It ain't what you don't know that gets you in trouble, it's what you know for sure that just ain't so." Risk appears when there is a very high degree of confidence among market participants in a particular outcome that doesn't pan out. So, from that perspective, here are five global upside risks for investors in 2019, in no particular order: no yield curve inversion, a U.S.-China trade deal, a rebound in China's economy, no (disorderly) Brexit, and a change in market leadership.

1. No yield curve inversion

We have frequently called attention to the bear market and recession signal known as the yield curve inversion, when the 3-month U.S. Treasury yield exceeds the yield on the 10-year U.S. Treasury. The market seems to have become increasingly confident that the rapidly closing gap will lead to an inversion very soon. While that gap has narrowed dramatically, there is still a chance that it won't invert and signal another prolonged bear market for global stocks shown in the chart below.

The yield curve might avoid an inversion in 2019

Source: Charles Schwab, Bloomberg data as of 1/3/2019

For example, in 1998, the gap between the 3-month and 10-year yield narrowed to just 2 basis points before widening again, with stocks rebounding sharply following a correction in 1998. There were strong gains in 1999, and the global economy avoided entering a recession until 2001 (after the yield curve inversion finally took place in 2000). While it seems likely an inversion may happen in 2019, if the Fed goes on hold, inflation remains benign and financial conditions ease, the gap in Treasury yields could widen again and the stock market could rally.

2. U.S.-China trade deal

The market seems very skeptical of any real breakthrough on US-China trade negotiations. This week, officials meet in Beijing for the first face-to-face talks since President Donald Trump and President Xi Jinping agreed to a temporary truce on December 1. Since then, China has taken a number of actions to address U.S. concerns by:

Buying U.S. soybeans.

Approving U.S. rice imports.

Lowering tariffs on U.S. autos.

Downplaying the Made in China 2025 program.

Establishing new penalties and laws to restrict forced technology transfer.

But it remains to be seen whether this will be seen as sufficient progress towards a resolution by the March 1 deadline, which would avoid further tariffs. There may still be a lot of work to do, and there may not be enough time to work out the details or come to terms on contentious issues. It is also possible that all of the U.S. concerns cannot be resolved in a way that could reverse or halt any tariffs on a permanent basis.

Many investors seem convinced that President Trump has no intention of resolving this issue, which remains popular with his core base of support. Yet, skepticism also surrounded last year's trade deals, including the U.S. crafting a replacement to NAFTA. An end to the trade escalation with China would likely lift the stocks of multinational companies dependent upon trade for earnings growth and could even lift economic sentiment measures such as the purchasing managers' indexes, which seem to have been weighed down globally by trade fears.

3. China's economy rebounds

The consensus on China's economic outlook is pretty weak. The recent news from Apple (AAPL) citing surprising weakness in its business in China followed a drop in the country's manufacturing purchasing managers' index below 50, signaling contraction. The world's second-largest economy is a big driver of global growth, and the continuing slowdown has weighed on investors' outlook for profit growth not just in China but around the world - as you can see in the chart below.

Analysts' expectations for global earnings growth have been falling

Source: Charles Schwab, FactSet data as of 1/7/2019

Chinese policymakers have taken both fiscal and monetary policy actions in recent months to stimulate their economy. The stimulus may soon kick in. If there are some positive developments on the U.S.-China trade tensions, the combination could provide upside for stocks and an improvement in Chinese economic momentum.

4. No (disorderly) Brexit

Prime Minister Teresa May's Brexit deal seems likely to get a "No" vote from Parliament next week. That has many investors worried that the United Kingdom will go crashing out of the European Union at the end of March with no plan, resulting in a shock to world markets. Yet, there may be higher odds than the market thinks that a deal will get done to at least provide a transition period, and there is even a chance of no Brexit at all.

Brexit decision tree

Source: Charles Schwab as of 1/7/2018

While it is difficult to put any kind of odds on the various "No Deal" outcomes, it is clear there is more than one scenario. For example, there could be no deal on the future trade relationship but still an agreement on the much-less-contentious divorce settlement of 39 billion pounds, with a transition period of time to figure out trade agreements. This transition period would run from the end of March 2019 to December 2020 - that's a long time for changes to take place. All the while, companies are already preparing their businesses in anticipation. So, that would be very different scenario from simply flipping a switch to a disorderly Brexit.

There are other potential outcomes as well, including "No Brexit", which could be triggered by a second referendum taking place that reversed the first. Right now, there is little parliamentary support for another vote. So, an unanticipated vote for the deal would likely be seen as a positive by the markets, while a "No Deal" vote outcome on January 14 could trigger a chain reaction that could result in a recession in the United Kingdom. In the middle, there are scenarios where the impact might be fairly mild. Markets seem to be at least partially braced for a "No Deal" outcome already, with a sizeable drop in both the U.K. currency and stock market.

5. Change in market leadership

The best-performing sector of the past 10 years has been the tech sector, and the largest global stocks are well-known tech giants. It may seem that for stocks to rise, technology stocks must lead the way. This has led some investors to believe that without tech stock leadership, the stock market is doomed to fall.

However, a leadership change could offer the markets a second wind. Other sectors have led the markets in the past, including those that aren't growth stocks. In fact, history shows that late in the economic and market cycle (usually about a year before the global economic cycle ends), the market's style leadership changes. For example, looking back at the past 25 years or so in the chart below, we can see when the shifts in long-term relative performance have taken place.

The period of growth stocks outperforming value stocks began to reverse in early 2000, ahead of the 2001 recession. The next leadership shift took place in 2007 as leadership began to shift from value to growth stocks ahead of the start of the recession in 2008. Stock market leadership may again be starting to reverse ahead of the next recession.

While stocks peaked in 2000 as the leadership shifted, the stock market continued to rise for much of 2007 after leadership shifted. While we expect a challenging year for investors, a shift in leadership may act as a second wind for the market as a new group of stocks (where expectations may not be as stretched) help lift the overall market.

Be prepared

Whether or not these particular surprises come to pass, a new year almost always brings surprises in one form or another. Having a well-balanced, diversified portfolio and being prepared with a plan in the event of an unexpected outcome is a key to successful investing.